Venture Law Lines

Start-up and Tech Law Notes from a lawyer and former VC

Tuesday, October 30, 2007

Selling the Startup: Due Diligence Disasters

Last night I spent approximately 10 minutes poking around my right eye, attempting to remove a contact lens that, as it turns out, actually fell out on my first try. You really haven't lived until you've tried to pinch your iris. (Grooming tip: clip your fingernails beforehand. Your cornea knows when you've made an effort.) Damn you and your ultra-thin lenses, Acuvue!

Like me, startups can get all squinty-eyed once they've signed a term sheet to sell the business. They will allow wide-ranging access to their files and records so that due diligence can be completed as quickly as possible. This is a flawed and potentially dangerous strategy. Due diligence is rarely the reason why acquisitions proceed slowly or grind to a halt. The larger the acquiror, the more cumbersome the approval process. Until draft documents start crossing your doorway, it's best to provide phased, careful disclosure.

Consider what could happen if a deal falls apart once an acquiror has seen your customer lists and your customer contracts. What if the acquiror starts contacting your customers? As The Register reports, in a lawsuit filed in Delaware Chancery Court this summer this is exactly what Sunrocket claims happened to it after Vonage ended negotiations to buy the business. You can read more about the allegations, and Vonage's response over at The Register's site.

Other issues: What happens if, in the course of due diligence, your acquiror's team discovers infringing technology? Or trade secrets that are similar to their own? Can these form the basis for an infringement action once the deal is off? In larger transactions, using an outside entity to perform technolgy due diligence can remove this risk, but this is not a tactic regularly used in smaller deals. It should be, if there's a chance of overlapping technologies.

I spend a lot of time on the non disclosure provisions in offers to buy to try and deal with some of these issues. But the best protection, in my view, is controlled, phased due diligence. Don't let someone else stick a finger in your eye. Goodness only knows what might start oozing out.

Monday, October 29, 2007

Selling the Startup:Who Runs the Process?

In a startup, selling the business tends to be an opportunistic thing, rather than part of a planned corporate strategy. Which means that, the question of who should manage the process of selling the business, is often not addressed until a serious expression of interest has been received from a potential acquiror. What next?

In a public company, the path is set: designate a special committee of the board, composed almost exclusively of independent directors, and hire an advisor to shepherd the process and ultimately render an opinion as to the fairness of the transaction.

In an emerging company, the course is less clear. For one thing, "independent" directors often are not truly independent; many are past investees of VCs brought on because of their industry/channel/technical expertise. They often lack the acquisition experience that would make this an effective delegation of the process.

By default, then, CEOs are often tempted to allow their VCs to spearhead the effort while they focus on operations. After all, they reason, a director owes a general duty to act in the best interests of all shareholders. Right? Not necessarily.

Before we go further, my usual disclaimer: as a general rule, I love VCs. Put a little ketchup on them, and they taste just like chicken. But they don’t necessarily have the skills to act as your quasi-investment banker. This is particularly true outside of Silicon Valley, where most funds have a limited track record of successful exits. Negotiating a financing or a term sheet with a portfolio company is NOT the same thing as negotiating a sale with a large acquiror. For one thing, the leverage is reversed for what VC used to, and some VCs find it hard to be the supplicant.

In addition, many VCs are not hard-wired to negotiate aggressive terms outside of the investing context. VCs are in the business of cultivating deal flow. Deal flow comes from relationships. This does not make them predisposed to be aggressive when you are in discussions with, say, a Cisco or an IBM.

More importantly, your VCs may not owe you any obligation to consider your best interests in shaping an acquisition. Consider your company’s structure; in most VC-backed companies, it is VCs who control the board and the corporation, thanks to a combination of protective provisions and preferred stock rights. As a recent article by two Berkeley law professors points out, this level of control may entitle VCs to do as they please when selling the business, without regard for the common shareholders. The authors point to the Delaware court ruling in Orban V. Field that "when the preferred control the board, directors do not owe a fiduciary duty specifically to the common shareholders and have wide discretion to benefit the preferred shareholders instead."

Don't overlook another tactical issue: time with the acquirer allows management to size up the opportunities available for you post transition, and even shape compensation in a way that allows you to recoup some of the sale proceeds that might otherwise be lost. Don't give that tactical advantage away too quickly.

The solution? For many, the board as a group might oversee the sale, without a special committee. An outside advisor can also be effective, if cash permits (and yes, I know some of you have very jaded views on this). But whatever else, management should not disengage from the frontlines. Time to suit up.

Thursday, October 25, 2007

What's Next for VCs?

Trolling through the junior exchange listings in Toronto might give you a clue. Take a look at Echelon Capital, whose listing was accepted last month by Toronto's Venture Exchange. The shell company raised a minimal $300,000 to go out and look for a business to acquire. Some have predicted that the exchange will become (a) a good parking lot for old portfolio companies that can re-purposed in the public markets, by spinning off related businesses and (b) will give new life to funds whose management fees are running low. Time will tell.

The directors and officers of Echelon? The present and former partners of Mclean Watson, the Toronto VC behind Flonetwork and assorted other investments during the local dot-com boom. I don't know what their underlying strategy is, but you can be sure I'm going to watch with interest. Smart group of renaissance guys who ohave been known to enjoy both bow hunting and baroque music.

Wednesday, October 24, 2007

On Being An "Off the Grid" Startup

As it happens, I'm not Jewish. This will come as a surprise to a certain senior Manhattan lawyer who, for the first six months I worked with him, would send me memos addressed to "Ms. Dingwald" and, when he passed me in the halls on Fridays, would wish me Good Shabbos.

I'm not Baptist, either. My Alabama-born officemate could see that right away; if I came into our shared quarters, she would immediately find a reason to leave. Perfectly understandable. I mean, what if the Rapture came while we were drafting Hart-Scott filings? There she'd be, stuck spending eternity teaching me how to properly wear a scrunchie in my hair.

It's human nature to want to assimilate, or to be assimilated. In the business world, this imperative is captured by the concept of "best practices." And in the startup world, "best practice" is usually euphemistic for "that's how it's done in the Valley."

Now, I know that renaming my farfalle with pesto as kasha varnishkes won't make me Jewish. (It won't make it taste better, either.) What I don't know is why so many entrepreneurs persist in the view that blindly adopting the Silicon Valley practices is, well, kosher?

The reality is that 95% or more of North American startups are created outside of Silicon Valley. Many are created in fairly robust business generation centres such as Boston, and emerging centres such as Chicago and Raleigh-Durham. Just as many are created in regions where the startup infrastructure is small or non existant. Do the practices, deal terms, and operational decisions typically made by startups in the overheated Valley, with its cadre of serial entrepreneurs and super-angels, have any application for the rest of us, who are off the Silicon Valley grid?

Once we finish this whole "Selling the Startup" series we started, I'd like to focus blog entries on Off the Grid best practices. Thoughts, questions and comments are welcome ahead of time.

Monday, October 22, 2007

If Venture Capital is Dead, What's Next?

Sometime soon, pundits are going to officially declare that venture capital in Canada is dead. We’ve given it a good 15 years, they’ll say, but venture capital is not a sustainable business here.

They will point to the increasing number of defunct funds that no longer invest, keeping the doors open only to manage existing investments while the management fees last. Other VCs have either re-positioned themselves as asset managers or are in talks with their investors about returning to their origins as hedge funds.

The pundits will note the recent halting of efforts to raise new funds by prominent VCs. The root cause of this, they'll say, is the almost complete withdrawal of support by the pension funds and institutions that invest in venture capital funds. These backers have either: (a) gotten out of venture capital altogether, or (b) instead decided to invest their money in government initiatives, such as the new $90 million + seed fund that the Government of Ontario announced before the recent election.

All of these factors, the pundits will say, have led to a permanent sectoral decline. Venture capital in Canada is no longer an industry, but a financial product offered by only a handful of players.

When someone finally says this, I'll agree. But I'll also say that, as someone who advises entrepreneurs, I don't particularly care. All this tells me is that companies will now use different financial tools to feed growth, using business plans that are not shoehorned into the somewhat artificial venture capital model for growth - i.e., in and out in 3-7 years.

Here are the things to watch as we enter a new era of company creation:

1. The increase in advisors:there are many former VCs who are looking to stay in the game by providing advice and some modest seed capital out of their own pockets. They reckon that they can earn money in deal origination fees until they establish themselves and are able to raise a modest fund, much as Jeff Clavier has done. However, there are already many advisors who've been working in this space. Excess supply is always good news for the consumer - you, the entrepreneur. Tread carefully, though.

2. Increased government funding for seed investments and commercialization: the Ontario government has thrown almost unlimited amounts of money at a variety of initiatives to create public-sponsored infrastructure for startups. Which keeps the government agenda focused for the forseeable future on building an "innovation economy". Watch for additional funding options, managed by a new set of players. The federal government also is actively investing through EDC and Sustainable Technology Development Canada, among others. Can't attract money there? Consider moving part of your operations to Saskatchewan or New Brunswick.

3. New financial tools: there are a number of financial tools and structures that could attract a new kind of investor to early stage ventures. Look for a rise in the number of investments made through limited partnership structures and (for companies with some cash flow) capital pool companies. If venture capital funds are no longer part of your financing strategy, you are free to explore any model that meets the legitiamte needs of your backers.

4.Company creation through consolidation: Smart VCs will (and already are) looking for up-and-comers to bootstrap onto existing portfolio investments. There will be a near-term rise in the number of early acquisitions in some niches.

5. A return to seed investing by VCs:Venture Capital may no longer be an industry, but it's not extinct, either. There will still be funds, likely falling into two categories: (a) those who invest internationally, but retain local offices, and (b)those invest locally in emerging industries where Canada still could emerge as a world leader (clean tech, biotech and drug discovery/diagnostics). Ironically, local VCs ackowledge that they will have to play a greater role at seed stage or risk getting shut out by US VCs in later stage rounds, as was the case with iUpload.

6. Bootstrapping is the new black.Modifying business plans so that you grow only as funds allow is a return to basics, I know. But it works - ask RIM. There's also a number of creative models and ways to bootstrap, which we're seeing great examples here at our firm daily.

This is how I see the lay of the land, and it's all promising. Let's get cracking.

Saturday, October 20, 2007

On Being the Last Investment

I had a terrific team in my office recently, evaluating their financing options. One VC had told them, "We only have room in our current fund for one more investment, and we think you might make the cut." That's good news, they said. Right?

Wrong. On the one hand, a term sheet is always good news, especially if you're a startup outside Silicon Valley, where capital is still scarce. But, much like Twix bars, one VC is never enough. There will be further rounds of funding and startups need to think about how the investors you select now will figure into later rounds of funding, and later syndicates.

If a VC is telling you it's on its last investment, you need to find out whether it has closed its next fund. If the answer is no, then you have to consider how this will impact your ability to attract additional investors. I've heard it more than once from US VCs in particular: having a co-investor that may be a lame duck is a problem; they don't want to be left as the only ones supporting a portfolio company.

The logic doesn't necessarily flow. VCs typically reserve funds for follow-on investments, so in theory, even if you are their last investment, they will have reserved money in the current fund for further rounds. Nonetheless, other VCs have said, they worry about misaligned agenda; the other VC is more likely to push for an earlier exit. Failing that, they may sell their position in your company in the secondary market to an entirely different player altogether.

Right or wrong, the issue here is marketing perception and how the investors you team with impact your ability to syndicate. An issue to be approached gingerly.

Thursday, October 18, 2007

Random Thoughts from the M&A Side

It's been a busy fall, so blogging has been a little light. More on Selling the Startup in a few hours. In the mean time, here are assorted tips that I'd like to pass on as fall deal season heads into the home stretch:

1. Board Meetings: Always make sure your company charter and by-laws permit board meetings to be held by telephone. There may be times that you can't be there in person, no matter how urgent the meeting. For example, your children could have brought home lice from school. Maybe you need to cast your vote while being de-loused. Who can say for sure?

2. Executive Compensation: I understand that today's high-tech founders are very happening, active dudes, who enjoy sailboarding in shark-infested waters after a hard day of coding. Very impressive. But the rest of the world does not employ sail-boarder lingo. In the board room, the term "package" is generally used to discuss compensation. Or severance. Similarly, when your directors refer to "management team packages", they are not discussing anatomical attributes. You can all stop twittering.

About Me

Suzie is a partner with Venture Law Associates LLP in Toronto, Canada, a boutique law firm representing entrepreneurs and emerging companies. Admitted to the New York and Ontario bars, Suzie has worked on Wall Street and Bay Street and at Nortel Networks. Suzie's start up stripes were earned as part of the founding team of Saraide.com, a wireless data startup that was sold to Infospace for $470 million in 2000. A former VC, Suzie now advises private companies at all stages of growth. Suzie is also the founder of Corner Office Beauty, a beauty products and fragrances company.